Wednesday, March 17, 2010

Here is the beginning and end of a (much longer) Q&A with Gary Gorton
discussing the financial crisis. He explains how the crisis was generated by a bank run much like past bank runs, but in a different type of asset and in a different segment of the banking system.

Rather than a run by individual depositors on demand deposits held in traditional banks (or, further in the past, private bank notes), this run involved firms and institutional investors and it was on repo held in the shadow banking system:

Questions and Answers about the
Financial Crisis, Prepared for the U.S. Financial Crisis Inquiry Commission, by
Gary Gorton[open
link]: 1. Introduction ... Yes, we have been through this before,
tragically many times. U.S. financial history is replete with banking crises and
the predictable political responses. Most people are unaware of this history,
which we are repeating. A basic point of this note is that there is a
fundamental, structural, feature of banking, which if not guarded against leads
to such crises. Banks create money, which allows the holder to withdraw cash on
demand. The problem is not that we have banking; we need banks and banking. And
we need this type of bank product. But, as the world grows and changes, this
money feature of banking reappears in different forms. The current crisis, far
from being unique, is another manifestation of this problem. The problem then is
structural.

In this note, I pose and try to answer what I think are the most relevant
questions about the crisis. I focus on the systemic crisis, not other attendant
issues. I do not have all the answers by any means. But, I know enough to see
that the level of public discourse is politically motivated and based on a lack
of understanding, as it has been in the past, as the opening quotations
indicate. The goal of this note is to help raise the level of discourse.

2. Questions and Answers

Q. What happened?

A. This question, though the most basic and fundamental of all, seems very
difficult for most people to answer. They can point to the effects of the
crisis, namely the failures of some large firms and the rescues of others.
People can point to the amounts of money invested by the government in keeping
some firms running. But they can’t explain what actually happened, what caused
these firms to get into trouble. Where and how were losses actually realized?
What actually happened? The remainder of this short note will address these
questions. I start with an overview.

There was a banking panic, starting August 9, 2007. In a banking panic,
depositors rush en masse to their banks and demand their money back. The banking
system cannot possibly honor these demands because they have lent the money out
or they are holding long-term bonds. To honor the demands of depositors, banks
must sell assets. But only the Federal Reserve is large enough to be a
significant buyer of assets.

Banking means creating short-term trading or transaction securities
backed by longer term assets. Checking accounts (demand deposits) are the
leading example of such securities. The fundamental business of banking creates
a vulnerability to panic because the banks’ trading securities are short term
and need not be renewed; depositors can withdraw their money. But, panic can be
prevented with intelligent policies. What happened in August 2007 involved a
different form of bank liability, one unfamiliar to regulators. Regulators and
academics were not aware of the size or vulnerability of the new bank
liabilities.

In fact, the bank liabilities that we will focus on are actually very old, but
have not been quantitatively important historically. The liabilities of interest
are sale and repurchase agreements, called the “repo” market. Before the crisis
trillions of dollars were traded in the repo market. The market was a very
liquid market like another very liquid market, the one where goods are exchanged
for checks (demand deposits). Repo and checks are both forms of money. (This is
not a controversial statement.) There have always been difficulties creating
private money (like demand deposits) and this time around was no different.

The panic in 2007 was not observed by anyone other than those trading or
otherwise involved in the capital markets because the repo market does not
involve regular people, but firms and institutional investors. So, the panic in
2007 was not like the previous panics in American history (like the Panic of
1907, shown below, or that of 1837, 1857, 1873 and so on) in that it was not a
mass run on banks by individual depositors, but instead was a run by firms and
institutional investors on financial firms. The fact that the run was not
observed by regulators, politicians, the media, or ordinary Americans has made
the events particularly hard to understand. It has opened the door to spurious,
superficial, and politically expedient “explanations” and demagoguery. ...

The Panic of 1907

3. Summary

The important points are:

• As traditional banking became unprofitable in the 1980s, due to competition
from, most importantly, money market mutual funds and junk bonds, securitization
developed. Regulation Q that limited the interest rate on bank deposits was
lifted, as well. Bank funding became much more expensive. Banks could no longer
afford to hold passive cash flows on their balance sheets. Securitization is an
efficient, cheaper, way to fund the traditional banking system. Securitization
became sizable.

• The amount of money under management by institutional investors has grown
enormously. These investors and non‐financial firms have a need for a
short-term, safe, interest-earning, transaction account like demand deposits:
repo. Repo also grew enormously, and came to use securitization as an important
source of collateral.

• Repo is money. It was counted in M3 by the Federal Reserve System, until M3
was discontinued in 2006. But, like other privately-created bank money, it is
vulnerable to a shock, which may cause depositors to rationally withdraw en
masse, an event which the banking system – in this case the shadow banking
system—cannot withstand alone. Forced by the withdrawals to sell assets, bond
prices plummeted and firms failed or were bailed out with government money.

• In a bank panic, banks are forced to sell assets, which causes prices to go
down, reflecting the large amounts being dumped on the market. Fire sales cause
losses. The fundamentals of subprime were not bad enough by themselves to have
created trillions in losses globally. The mechanism of the panic triggers the
fire sales. As a matter of policy, such firm failures should not be caused by
fire sales.

• The crisis was not a one-time, unique, event. The problem is structural. The
explanation for the crisis lies in the structure of private transaction
securities that are created by banks. This structure, while very important for
the economy, is subject to periodic panics if there are shocks that cause
concerns about counterparty default. There have been banking panics throughout
U.S. history, with private bank notes, with demand deposits, and now with repo.
The economy needs banks and banking. But bank liabilities have a vulnerability.

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"Questions and Answers about the Financial Crisis"

Here is the beginning and end of a (much longer) Q&A with Gary Gorton
discussing the financial crisis. He explains how the crisis was generated by a bank run much like past bank runs, but in a different type of asset and in a different segment of the banking system.

Rather than a run by individual depositors on demand deposits held in traditional banks (or, further in the past, private bank notes), this run involved firms and institutional investors and it was on repo held in the shadow banking system:

Questions and Answers about the
Financial Crisis, Prepared for the U.S. Financial Crisis Inquiry Commission, by
Gary Gorton[open
link]: 1. Introduction ... Yes, we have been through this before,
tragically many times. U.S. financial history is replete with banking crises and
the predictable political responses. Most people are unaware of this history,
which we are repeating. A basic point of this note is that there is a
fundamental, structural, feature of banking, which if not guarded against leads
to such crises. Banks create money, which allows the holder to withdraw cash on
demand. The problem is not that we have banking; we need banks and banking. And
we need this type of bank product. But, as the world grows and changes, this
money feature of banking reappears in different forms. The current crisis, far
from being unique, is another manifestation of this problem. The problem then is
structural.

In this note, I pose and try to answer what I think are the most relevant
questions about the crisis. I focus on the systemic crisis, not other attendant
issues. I do not have all the answers by any means. But, I know enough to see
that the level of public discourse is politically motivated and based on a lack
of understanding, as it has been in the past, as the opening quotations
indicate. The goal of this note is to help raise the level of discourse.

2. Questions and Answers

Q. What happened?

A. This question, though the most basic and fundamental of all, seems very
difficult for most people to answer. They can point to the effects of the
crisis, namely the failures of some large firms and the rescues of others.
People can point to the amounts of money invested by the government in keeping
some firms running. But they can’t explain what actually happened, what caused
these firms to get into trouble. Where and how were losses actually realized?
What actually happened? The remainder of this short note will address these
questions. I start with an overview.

There was a banking panic, starting August 9, 2007. In a banking panic,
depositors rush en masse to their banks and demand their money back. The banking
system cannot possibly honor these demands because they have lent the money out
or they are holding long-term bonds. To honor the demands of depositors, banks
must sell assets. But only the Federal Reserve is large enough to be a
significant buyer of assets.

Banking means creating short-term trading or transaction securities
backed by longer term assets. Checking accounts (demand deposits) are the
leading example of such securities. The fundamental business of banking creates
a vulnerability to panic because the banks’ trading securities are short term
and need not be renewed; depositors can withdraw their money. But, panic can be
prevented with intelligent policies. What happened in August 2007 involved a
different form of bank liability, one unfamiliar to regulators. Regulators and
academics were not aware of the size or vulnerability of the new bank
liabilities.

In fact, the bank liabilities that we will focus on are actually very old, but
have not been quantitatively important historically. The liabilities of interest
are sale and repurchase agreements, called the “repo” market. Before the crisis
trillions of dollars were traded in the repo market. The market was a very
liquid market like another very liquid market, the one where goods are exchanged
for checks (demand deposits). Repo and checks are both forms of money. (This is
not a controversial statement.) There have always been difficulties creating
private money (like demand deposits) and this time around was no different.

The panic in 2007 was not observed by anyone other than those trading or
otherwise involved in the capital markets because the repo market does not
involve regular people, but firms and institutional investors. So, the panic in
2007 was not like the previous panics in American history (like the Panic of
1907, shown below, or that of 1837, 1857, 1873 and so on) in that it was not a
mass run on banks by individual depositors, but instead was a run by firms and
institutional investors on financial firms. The fact that the run was not
observed by regulators, politicians, the media, or ordinary Americans has made
the events particularly hard to understand. It has opened the door to spurious,
superficial, and politically expedient “explanations” and demagoguery. ...

The Panic of 1907

3. Summary

The important points are:

• As traditional banking became unprofitable in the 1980s, due to competition
from, most importantly, money market mutual funds and junk bonds, securitization
developed. Regulation Q that limited the interest rate on bank deposits was
lifted, as well. Bank funding became much more expensive. Banks could no longer
afford to hold passive cash flows on their balance sheets. Securitization is an
efficient, cheaper, way to fund the traditional banking system. Securitization
became sizable.

• The amount of money under management by institutional investors has grown
enormously. These investors and non‐financial firms have a need for a
short-term, safe, interest-earning, transaction account like demand deposits:
repo. Repo also grew enormously, and came to use securitization as an important
source of collateral.

• Repo is money. It was counted in M3 by the Federal Reserve System, until M3
was discontinued in 2006. But, like other privately-created bank money, it is
vulnerable to a shock, which may cause depositors to rationally withdraw en
masse, an event which the banking system – in this case the shadow banking
system—cannot withstand alone. Forced by the withdrawals to sell assets, bond
prices plummeted and firms failed or were bailed out with government money.

• In a bank panic, banks are forced to sell assets, which causes prices to go
down, reflecting the large amounts being dumped on the market. Fire sales cause
losses. The fundamentals of subprime were not bad enough by themselves to have
created trillions in losses globally. The mechanism of the panic triggers the
fire sales. As a matter of policy, such firm failures should not be caused by
fire sales.

• The crisis was not a one-time, unique, event. The problem is structural. The
explanation for the crisis lies in the structure of private transaction
securities that are created by banks. This structure, while very important for
the economy, is subject to periodic panics if there are shocks that cause
concerns about counterparty default. There have been banking panics throughout
U.S. history, with private bank notes, with demand deposits, and now with repo.
The economy needs banks and banking. But bank liabilities have a vulnerability.